Small Caps Boast Big Advantages

Sometimes, buying stock in small capitalization companies - those with market caps of between $300 million and $2 billion - is more profitable than buying shares in large caps. In fact, according to Ibbotson Associates, an investment-consulting firm that also tracks long-term market data, small caps have increased in value by an average of more than 12% per year between 1927 and 2007. Meanwhile, large caps have increased just over 10% during that same time period.

This performance advantage is no coincidence. In fact, small caps have several advantages that large caps simply can't match. Read on as we cover how small caps can produce big gains and how you can pick a winner.

Temporary Valuation DisconnectSmall caps may outperform larger companies over time, but the operative words here are "over time." That's because smaller companies, primarily because of their lack of visibility within the investment community, often experience a disconnect between their stock prices and their fundamentals. This discrepancy between price and fundamentals presents a tremendous opportunity that small cap investors can take advantage of.

Thin MarketSmall caps tend to be thinly traded, and while this is a characteristic that can slice both ways, it often presents a huge opportunity for shrewd investors. As the company grows its revenues and earnings over time and the public becomes more aware of its existence and future growth prospects, demand for the stock inevitably perks up. And when a large number of investors start to clamor over a very limited amount of stock, this gives small cap stocks the potential to rise quite rapidly.

Lack of Analyst Coverage According to First Call, on Jan. 8, 2007, UBS Securities raised its rating on IBM from "neutral" to "buy." The stock edged up $1.17 on the news, or about 1%. But that move was nothing compared to what happened on Sept. 6, 2005, when Brean Murray upgraded Wilson's Leather from "accumulate" to "strong buy." The day the report went out the shares moved up roughly 4%, and within a week they rose almost 12%!

Why the discrepancy between reactions?

It's simple. At the time of the IBM upgrade, about 25 different analysts were covering the stock. This meant that there was a great deal of information already in the public domain, and it would take a major news announcement or an unusually bullish report or group of reports to move the stock substantially. However, at the time, only about five different brokerage firms had disseminated research on Wilsons. As such, the investment community was more apt to react in a positive manner.

Institutional Sponsorship With regard to the benefits of institutional ownership, a terrific example can be found in a small cap called Labor Ready, which changed its name to TrueBlue Inc. (NYSE:TBI) in 2007. Back in late 1997, the temporary employment provider was trading in the mid-single digits. However, its then Chief Executive Glen Welstad went on several road shows where he met with a number of institutions, which warmed to the stock almost immediately.

The result of Welstad's aggressive public relations campaign was nothing short of amazing. Within a year's time, a number of big-name funds got involved in the stock and the shares skyrocketed into the $25 range.

Eric Schmidt, who headed up Novell and later moved on to Google, once said in a conference call that big companies were like aircraft carriers or cruise ships, "they take a long time to change direction."

In many ways, this is a perfect analogy. In fact, it can take years for a larger company to bring a new product to market because of the committees that need to review its practicality (before its introduction), the legal vetting it must receive and the work that goes into its marketing and promotion. Small companies, on the other hand, have less bureaucracy and a genuine need to push products to market just to survive.

Take, for example, a small-cap restaurant business that has operations dispersed throughout the United States. Over time, this type of company would be able to refurbish its locations and make menu changes many times within a period of weeks or months. However, similar changes would be impossible for a restaurant giant like McDonald's (NYSE:MCD), which had more than 30,000 restaurants in 2007 - not to mention a bulky senior management staff with a reputation for moving at glacial speed.

The ability to be nimble enables a small company to seize opportunities (enter new markets, release new products, etc.) in a much more efficient way than its large cap counterparts. This allows it to grow sales and earnings at a 20 or 30% rate, whereas most corporate behemoths tend to experience mere single-digit growth.

Less InfightingConsider some of the infighting that takes place at large cap companies. It's incredible! Morgan Stanley is a great example. In 2004 and 2005, the well-known investment bank saw many of its top analysts and bankers leave the firm. At issue was an ongoing fight by two internal camps. One camp supported the chief executive, Philip Purcell, the architect of the Dean Witter/Morgan Stanley merger. The other camp blamed Purcell for sluggish stock price performance, and yearned for its former president, John Mack, to take the helm.

It turns out that Mack won the battle. But Morgan Stanley investors ultimately lost as key revenue driving employees left and the stock languished.

While smaller companies are not immune to such battles, there usually isn't as much at stake to fight over in terms of responsibility, publicity, salary, bonuses or perks. Companies that can avoid infighting and minimize bureaucracy often have an inherent advantage over those that can't.

AcquisitionsWhile larger companies can and do merge with or acquire other large companies, it doesn't happen very often. On the other hand, smaller companies always seem to have a target on their backs.

That's why, as of 2007 companies such as Isle of Capri Casinos, a casino operator in the Southeast, or Ameristar Casinos, a casino operator in the Midwest tend to do so well even during tough economic times. The ongoing possibility that they will be bought out by larger players acts as a perpetual catalyst for the stock.

It's also much easier for a large company, which probably has pretty deep pockets, to buy a small company that's already up and running than it is for the larger company to start a comparable operation from scratch.

The fact that smaller companies often have a target on their backs and that larger companies are often willing to pay a premium to acquire them makes small caps all the more attractive.

The Bottom LineSmall caps aren't necessarily a panacea for all portfolios, but they do have operational advantages that their larger cap counterparts do not. Factors such as being thinly traded or not having many analysts cover the stock may act as a double-edged sword but, for the astute investor, these factors can actually present a great deal of opportunity.

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